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Partial budgeting: Making incremental farm business changes | KTIC Radio

Partial budgeting: Making incremental farm business changes

Partial budgeting: Making incremental farm business changes

NORTH PLATTE, Neb. — Business owners must often make decisions about changes they are either contemplating or changes that have to be made. Many of the decisions are incremental, such as adding land, expanding or reducing an enterprise, adding an enterprise or changing how an enterprise is managed. Analyzing the whole farm impacts for these types of changes is unnecessary. The partial budget is a useful tool for farm managers when these situations arise.

A partial budget helps farm owners/managers evaluate the financial effect of incremental changes. A partial budget only includes resources that will be changed.  It does not consider the resources in the business that are left unchanged.  It is important to remember, only the change under consideration is evaluated for its ability to increase, or decrease, income in the farm business.

 

Partial Budgeting Principles

Partial budgets are based on the principle that small business changes have effects in one or more of the following areas.

  1. Increase in income
  2. Reduction or elimination of costs.
  3. Increase in some costs.
  4. Reduction or elimination of income.

The net impact of the above effects will be the positive financial changes minus the negative financial changes. A positive net indicates increased farm income due to the change while a negative net indicates the change will reduce farm income.

 

Partial Budget Components

A partial budget consists of two columns, a subtotal for each column and a grand total. The left hand column has the items that increase income while the right hand column notes those that reduce income for a farm business. Figure 1 illustrates the use of the partial budget for purchased versus raised beef replacements. The partial budget can be divided into four parts.

  • Added Income

This area is usually an estimate if a new enterprise is to be added. Use realistic yields, product quality and prices. Over-estimation may lead to incorrect decisions and possibly reduced financial performance when the change was meant to improve it. When deciding on price, use average prices from the most likely market where production is most likely to be sold. Also use average quality unless the change under consideration is meant to improve crop or livestock quality.

Income increases may come from expansion of an enterprise. If the expansion is minor, current production quantities, quality and average prices are reasonable approximations to use. But if the expansion is large, during the early production periods, lower yields and quality may result due to start-up difficulties. Take this factor in consideration when estimating income.

  • Reduced Costs

Obvious items for inclusion in the section would be crop or livestock expenses no longer incurred. These costs could be reductions or total elimination of certain expenses. Examples include seed, custom work, repairs, veterinary expense, interest expense and paid or unpaid labor. Inclusion of non-cash costs, unpaid labor and depreciation, would provide a full economic analysis but may skew the cash change analysis.

  • Additional costs

This is the first section of Column 2. Here is a list of the increased expenses due to the change being considered. Most of these will be costs of production for the new enterprise. This list may also include non-cash costs such as labor and depreciation, but if they are included, the results of the analysis will not provide the change in cash income for the management change. It might be appropriate, however, to include unpaid labor to be certain that the operator is equitably paid for his/her labor and management input. A depreciation charge, if included, will help analyze whether there is a return on the investment the operator makes.

  • Reduced Returns

This section follows ‘Additional Costs.’ These two sections are included in the same column since both reduce net income. Items to include here might be reductions in product sales, such as corn, feeder pigs, apples or milk, rental income, custom work income, or USDA payments. Another consideration here may be reductions in yields due to reduced planting or harvest timeliness. When utilizing custom operators or shared ownership of equipment, some cropping operations may not be completed in as timely a manner as desired in some years. This can reduce quality and yields that reduce farm income. Accurately estimating this factor can be difficult, however.

 

Partial Budget Summary

The summarization of the of the above four partial budget components is the last step in partial budgeting. Total each of the two factors in column 1 and write this result on the column 1 subtotal line. Repeat the process for column 2. Then take column 1 (added income/reduced cost) and subtract column 2 (increased costs/reduced income) to arrive at a projected net return from adoption of the change under consideration. A negative number, as in the example above indicates the change as considered will likely reduce whole farm income. A positive number indicates the opposite is likely to happen.

 

Conclusion

Partial budgeting can be useful in the decision process farm owners and managers use to decide on alternative uses of resources they have in their business. Partial budgeting is a systematic approach that can assist the manager in making informed decisions. But this budgeting process can only estimate possible financial impact, not assure it. Management aspects and serendipity can change the projections. Also the specific numbers used may not reflect realistic possibilities. These may result in better or poorer than expected performance. Careful assessment of possible farm changes will help prevent inaccurate projections of the change’s impact on the farm business.

Figure 1.

Partial Budget Example: Switch to purchased versus raising replacements

Column 1Increased income due to change: Column 2Increased costs due to change:
Sell raised heifer calf: 500lb x $1.20= $600 Purchase bred heifer           $1200
Subtotal                                                $600 Subtotal                                 $1200
Reduced costs due to change: Reduced income due to change:
Pasture maintenance:                              $20
Feed:                                                     $205
Health, utilities, misc:                          $105                                                             $0
Subtotal                                        $930 Subtotal                                  $1200
Change in income:(subtotal from Column 1 minus subtotal Column 2)            $930 – 1200 = (270)
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